Idiosyncratic Risk, Investment And Industrial Diversification

Idiosyncratic risk of the U.S. stock market in recent years showed a rising trend.Scholars have played more and more attention to the study of idiosyncratic risk andachieved breakthrough, including research on the relationship of idiosyncratic risk andcorporate decision-making. Due to the significant increase in idiosyncratic risk,managers had to reduce the physical investment of the company in order tocircumvent the idiosyncratic risk. Based on the breakthrough study, this paperexplores how and in what extend the idiosyncratic risk affects the Chinese listedcompanies’ strategic decision.735listed companies in Shenzhen or Shanghai stock exchange from2000to2010are selected in this paper. That is a total of5134observations. By usingKolmogorov-Smirnov test, OLS multiple regression and LOGIT regression method,it finds out1) idiosyncratic risk’s impact on the company’s decision-making, such asthe physical investment, diversified operation;2) the significant role that managersand shareholders play in the process of increasing idiosyncratic risk affects thecompany’s decision-making.First, it argues that if the stake of managers of listed companies in China is verylow (approximately0.02%), the idiosyncratic risk shows a weak correlation with thephysical investment decisions and a significant correlation with the degree ofdiversification operation. Diversifying business can not only circumvent theidiosyncratic risk, but also brings managers great private benefits. Therefore,managers add business diversification rather than reduce investment in order tocircumvent the idiosyncratic risk. Second, more incentive pay the managers get, theirsmaller desire to seek personal interests through corporate decision-making, and theweaker positive correlation between idiosyncratic risk and diversification businessshows. As managers’ incentive compensation increases, the correlation ofrisk-diversification weakens. Third, it states that the first shareholder of the companyalso plays an important role in diversification decision-making. If the first shareholderholds higher proportion of the stocks, the idiosyncratic risk and diversification show astronger correlation due to the greater demand for risk aversion. When the firstshareholder holds lower proportion of the stocks, the idiosyncratic risk anddiversification show a weaker relationship because of the oversight role they play. Generally, managers and the first shareholders both support businessdiversification policy in order to circumvent the idiosyncratic risk, which leads to asignificant and positive correlation between idiosyncratic risk and the extent ofdiversification. As managers get more incentive compensation or the first shareholderholds smaller proportion of the stocks, the positive correlation of risk anddiversification becomes weaker. As managers get less incentive compensation or thefirst shareholder holds bigger proportion of the stocks, the positive correlation of riskand diversification becomes stronger.